Cover Article

Momentum: The Engine That Drives SMI’s Investment Strategies

Dec 20, 2018
Listen to Article:

A defining characteristic of SMI’s strategies is they operate according to objective rules. They don’t rely on predictions or subjective thinking about how the stock market will perform best over the next year. Instead, they are driven by momentum, a remarkably simple metric that has guided our investing strategies successfully for nearly three decades. This article takes a closer look at momentum — what it is, how it works, why SMI adopted it, and how it’s applied to our strategies.

A fundamental mistake many investors make is to move too quickly in choosing investments. They read about a hot stock or this year’s best-performing mutual fund and jump in. It’s all very ad hoc and reactive.

A better approach is to choose a good investment strategy and allow it to guide you to the best investments. In other words, when deciding what to invest in, process matters. That’s what a good investment strategy is — a systematic, comprehensive process for determining what investments to purchase, how long to hold them, and when it comes time to make a change, what new investments to buy.

The best investment strategies are marked by: 1) objectivity, 2) clarity, 3) a good track record, and 4) ease of implementation. Since its founding in 1990, Sound Mind Investing has delivered strategies that meet those criteria with the help of a simple yet powerful indicator known as momentum.

Recent past is prologue

Momentum is the idea that recent past performance tends to persist — that is, it tends to continue, at least into the near-term future. Mutual funds that have performed well over the past several months tend to continue performing well for the next several months, just as funds with poor recent performance tend to continue performing poorly.

Think of it as Sir Isaac Newton’s first law of motion applied to investing: “A body in motion tends to stay in motion unless acted on by an outside force.”

This runs counter to what most investors have learned. You’ve probably heard countless warnings that “past performance is no guarantee of future results.” So, this idea that recent past performance tends to persist may give you pause. All investment prospectuses are required to carry the “past performance” disclaimer, and for good reason. No investment comes with guaranteed returns, and an investment’s longer-term performance (3-, 5-, or 10-years) has been found to have virtually no predictive value.

That’s why mutual-fund rating systems that rely on those metrics, such as Morningstar’s star rankings, have been proven to be such poor guides to choosing funds. According to a Wall Street Journal analysis of Morningstar’s approach, “Of funds awarded a coveted five-star overall rating, only 12% did well enough over the next five years to earn a top rating for that period; 10% performed so poorly they were branded with a rock-bottom one-star rating.”

However, an investment’s near-term past performance, specifically how it has done over the past 3-12 months, has been found to be strongly predictive of how it will perform in the near-term future.

A long, well-researched history

Long before it became known as “momentum investing,” this idea got the attention of British economist David Ricardo (1772-1823). A respected thinker often mentioned along with well-known classical economists such as Adam Smith and John Stuart Mill, Ricardo was also a successful investor. As Wall Street Journal columnist Jason Zweig has noted, Ricardo built a fortune by adhering to certain “golden rules,” such as, “cut short your losses” and “let your profits run on.”

That’s a solid basic description of trend following, which is what momentum investing is — investing in a stock or mutual fund that’s been generating a positive return recently, staying with it until its momentum begins to wane, and then moving on to another strong-performing investment.

Momentum is such a simple idea that its effectiveness may seem surprising. After all, there are countless more sophisticated investment ideas in use today — from highly analytic ways of trying to identify undervalued companies to looking for the convergence of multiple patterns in performance charts. And yet, momentum’s simplicity is one of its strengths. If you’re going to put your hard-earned money at risk in the stock market (every investment involves risk), it’s a mark of good stewardship to use an investment strategy that’s as easy to understand as it is effective.

Think of it this way. As the football season hits the mid-way mark, which teams are most likely to make it to the Super Bowl — the teams that have won the most games over the past five years or the teams that have won the most games recently? Of course, it’s the teams with the best records this year. The same is true with investments, such as mutual funds.

But momentum investing doesn’t just make intuitive sense. Its effectiveness has been proven in many research studies. In 1993, Emory University economics professor Narasimhan Jegadeesh and University of Texas economics professor Sheridan Titman looked at a strategy that “selects stocks based on their past 6-month returns and holds them for 6 months.” Their paper has become one of the best-known studies about momentum investing. It concluded, “Trading strategies that buy past winners and sell past losers realize[d] significant abnormal returns over the 1965 to 1989 period.”

According to Business Insider, as of 2011, over 300 momentum papers had been published in academic journals. In 2014, when global investment-management firm AQR scanned the vast landscape of momentum research, it found, “[Momentum’s] return premium is evident in 212 years of U.S. equity data (from 1801 to 2012) — as well as U.K. equity data dating back to the Victorian 40 other countries and in more than a dozen other asset classes. Some of this evidence predates academic research in financial economics, suggesting that the momentum premium has been a part of markets for as long as there have been markets.”

One of the most recent investigations was a 2018 study by the Hartford Investment Management Company (HIMCO), which sought to find out whether the 1993 findings generated by professors Jegadeesh and Titman would hold up today. After applying their approach to stock prices from 1990 to 2016, HIMCO’s Paul Bukowski declared momentum to be “still alive and well.”

The premiere anomaly

Even those whose life’s work would seem to refute the possibility that momentum could be effective have found themselves at a loss to explain how momentum could work so well, yet they are convinced it does.

In 2013, University of Chicago economist Eugene Fama was awarded the Nobel Prize for his work on the Efficient Market Hypothesis (EMH), which argues that stocks always trade at their fair value because information about them is quickly and efficiently factored in to their prices. Therefore, according to the theory, it’s pointless to search for undervalued stocks or to look for trends that would lead to outperformance.

However, Fama has acknowledged several “anomalies” — strategies that defy what would be expected from a purely efficient stock market. As he and Dartmouth finance professor Kenneth French wrote in a paper they co-authored in 2008, “the premiere anomaly is momentum. Stocks with low returns over the last year tend to have low returns for the next few months and stocks with high past returns tend to have high future returns” (emphasis added). More recently, Fama went so far as to call momentum “the biggest embarrassment to the efficient market hypothesis.”

Why momentum works

Of course, the stock market is made up of individual market participants — people, who are often far from efficient or rational. In an ironic nod to that reality, in the same year that the Nobel Committee honored Eugene Fama for his Efficient Market Hypothesis, it also awarded the same prestigious prize to another economist, Yale’s Robert Shiller, whose work highlights just how inefficient the market can be.

In the run-up to the financial crisis of 2007-2008, Shiller sensed that excessive optimism had driven many people to buy homes they could not afford, creating a housing “bubble” that, if it were to burst, would cause painful consequences. Sure enough, many thousands of people lost their homes to foreclosure and several major financial institutions either went out of business or had to be bailed out by the federal government.

Surprisingly, the willingness of economists to consider emotional factors as drivers of financial decisions is somewhat new. Shiller credits the blending of psychology, sociology, and political science into economics for “bringing economics into a broader appreciation of reality."

One of the foremost social scientists to bring attention to the often irrational realities of economics is Daniel Kahneman, a psychologist whose work has been instrumental in the development of what is now known as “behavioral economics.” The field traces its roots to the 1970s when Kahneman and psychologist Amos Tversky began a long collaboration that explored the many cognitive biases that drive so much human behavior.

It is within this field of behavioral economics where momentum may be best understood. In particular, two cognitive biases may explain why momentum works: conservatism and herding. With conservatism, people react slowly to new information — for example, investors respond to good news about an investment they hold by gradually continuing to invest more. Herding is when investors see others making a particular investment and join in. Both behaviors can bid up the price of an investment, at least for a while.

Systematizing momentum

Not much is known about how David Ricardo decided when to cut short his losses or how long to let his profits run on. But in order to move from a philosophy of investing to a reliable, executable strategy, more specifics are needed. Objective ways of quantifying momentum are required so that investors know when an investment’s momentum is strong enough to justify its purchase and when that momentum has weakened to the point of making it prudent to sell.

Ben Carlson, author of the book A Wealth of Common Sense and a blog by the same name, put it this way: “It is a terrible idea to chase performance if you don’t know what you’re doing or why you’re doing it. Momentum is chasing performance, but in a systematic way, with an entry and exit strategy in place.... The best momentum investors use a rules-based approach, to avoid [making emotional decisions].”

The development of SMI’s momentum strategies

In 1980, SMI founder Austin Pryor was a money manager who enjoyed early success following the principles of market timing, moving client money into and out of the market when he and his business partner anticipated significant market strength or weakness.

His firm’s success continued for many years, but in the latter half of the 80s, the bottom fell out. In the spring of 1987, with the Dow Jones Industrial Average at about 2,300, Austin and his partner believed the market had risen too far too fast, and put all of their clients’ money into money-market funds. When the Dow kept rising throughout that summer, many clients, disappointed with missing out on the continuing rally to above 2,700, took their money elsewhere. On October 19, the market crashed. Now known as Black Monday, the Dow dropped more than 22% that day to below 1,750. Austin’s earlier move to safety was vindicated, but none of the clients his firm lost returned.

It was a painful time that led Austin into an extended period of praying for God’s direction. An answer came in the fall of 1989 over lunch with good friend Larry Burkett, a prolific biblical money-management author and host of a popular nationally syndicated radio program. Larry told Austin the Christian community needed a monthly investment newsletter to guide them through the investing process with clear instruction and biblical counsel.

While Austin readily agreed that such a publication would be beneficial, it didn’t initially occur to him that he should create it. But in the weeks that followed, he felt the Lord’s encouragement to take up the challenge, and he launched Sound Mind Investing in July 1990.

Given his 10+ years of experience as a market timer, one might think he would bring that emphasis into his newsletter venture. However, he knew that doing it successfully required more trading than was possible with a monthly publication. It also required a great deal of time, flexibility, and self-control. So, in contrast to the emotionally challenging, short-term mindset of market timing, Austin decided to emphasize the wisdom of taking a long-term perspective. Proverbs 13:11b says: “He who gathers money little by little makes it grow.”

He also knew from experience that the use of objective, mechanical rules to guide one’s investment strategy provided a needed guardrail against emotional decision-making. From the outset, Austin based his investment recommendations in SMI on momentum, an approach he had used in varying degrees in managing his clients’ assets.

He was especially intrigued by an approach to momentum investing used by Burton Berry, founder of a mutual-fund newsletter called NoLoad Fund-X. However, given that SMI was initially designed to appeal to novice investors, Austin devised a somewhat simplified version of Berry’s approach that would involve less buying and selling. That led to SMI’s first momentum investing strategy, Fund Upgrading.

SMI’s momentum strategies today

  • Fund Upgrading continues to be one of SMI’s “core” strategies, meaning it can be used to manage an investor’s entire portfolio. To follow Upgrading, the investor first determines an optimal asset allocation, using SMI’s risk-tolerance questionnaire (found in the Start Here section of the SMI website). Then he or she combines those findings with an investment time frame to come up with an ideal mix of stocks and bonds.

    If the investor’s optimal asset allocation is 100% stocks, the portfolio is divided equally among three stock risk categories: small company funds, large company funds, and a "situational" category that includes foreign, commodities, and other types of funds." If the optimal asset allocation calls for the use of bonds, that portion of the portfolio is invested across three bond funds — two that are fixed and one that changes based on momentum.

    Within each of the stock categories and the rotating bond category, the momentum scores of hundreds of funds are evaluated each month. The recommended funds are those with the highest momentum, calculated simply by adding together a fund’s most recent 3-, 6-, and 12-month performance. For example, if a fund has lost -2.0% over the past 3 months, gained +4.5% over the past 6 months, and gained +7.0% over the past 12 months, its momentum score would be 9.5.

    Notice that the most recent three-month’s performance is reflected in all three figures. It represents 100% of the first number, 50% of the second number, and 25% of the final number. In this way, a fund’s most recent performance is given greater weight. This formula reflects SMI’s experience that (1) the older the performance data, the less relevant it is, and (2) more recent months should be weighted more heavily than distant months.

    As long as a recommended fund’s momentum score keeps it within the top 25% of all the funds in its risk category, it remains a recommended fund. Once it drops below that top quartile, it is replaced with the then highest-momentum fund. This approach to using momentum is known as relative momentum. That means the performance of a fund within a given category is compared to other funds in the category.

    Over time, SMI’s ongoing research has led to a number of refinements to Fund Upgrading. In early 2018, for example, new defensive protocols based on the principles of absolute momentum were incorporated into the Fund Upgrading strategy. Recommended funds are still selected by comparing one fund’s performance against all others in its category. However, one aspect of the new protocols is to compare each fund’s momentum against its own recent past performance. This process will objectively move investors out of particular stock funds and into cash should a steep and persistent negative (bearish) trend develop.

    For the next two strategies, the exact momentum formula used to rank funds varies somewhat from the one employed with Fund Upgrading, but the same principles drive each of them.

  • Sector Rotation was launched in 2003. This is a high-risk, high-reward strategy that investors are advised to limit to no more than 20% of their stock allocation (conservative investors are advised to establish even lower limits, like 10% or less). In other words, if your optimal asset allocation is 80% stocks and 20% bonds, SMI recommends limiting SR to no more than 16% of your portfolio (20% of the 80% stock allocation).

    With Sector Rotation, SMI monitors the momentum of over 100 concentrated “sector” funds, such as those that invest only in telecommunications or bio-tech companies. As with Fund Upgrading, after the fund at the top of the list is first recommended, it is held until its momentum drops it below the momentum of the top 25% of funds in the SR universe. At that point, it is replaced with the sector fund currently at the top of the rankings.

    While Sector Rotation is SMI’s highest-volatility strategy, momentum has objectively guided those following the strategy to remarkable returns.

  • Dynamic Asset Allocation is the most recent SMI momentum strategy, introduced in 2013 to add a more defensive strategy to SMI’s lineup. Like Fund Upgrading, DAA is a core strategy, suitable for a significant portion of an investor’s portfolio. However, whereas Fund Upgrading is a strategic asset-allocation strategy (an investor’s portfolio is designed around their optimal stock/bond allocation, with momentum dictating which particular stock or bond funds to hold), DAA is a tactical asset-allocation strategy, rotating investors among six broad asset classes, each one represented by an exchange-traded fund: U.S. stocks, foreign stocks, real estate, bonds, gold, and cash.

    Those categories were chosen because they tend to be somewhat uncorrelated with each other. In other words, if some are performing poorly, others are likely to be performing better. Investors following the strategy hold the three funds showing the highest momentum.

    While Fund Upgrading and Dynamic Asset Allocation could be used to manage your entire portfolio, perhaps with a relatively small allocation to Sector Rotation, SMI research has demonstrated that the use of all three strategies may be the most profitable approach of all, lowering overall portfolio volatility while increasing returns.

    SMI also offers an indexing strategy, Just-the-Basics, that doesn’t utilize momentum. It’s a good choice for investors who are just getting started with investing, have relatively small portfolios, or are investing through a taxable account.

Necessary cautions

Historically, the biggest complaints against momentum investing have had to do with the perception that it requires frequent trading, and as a result, generates excessive trading costs. There are many iterations of momentum investing, and while some may involve repeated trading, one of SMI’s guiding principles in constructing our strategies has been to provide compelling performance while minimizing trading.

Although momentum investing has an impressive long-term record, it can go through periods of underperformance — especially at market turning points. As a trend-following approach, momentum positions us in what is working now. When a trend changes, it takes time to adjust a portfolio to the new trend.

These points are evident in DAA’s back-tested performance during the 2007-2009 bear market. Over the course of those tough 16 months, DAA would have lost money in 10 of them. However, because of the way the strategy responded to the changing market trends, DAA would have lost only -1.4% during that entire bearish period when the stock market was ravaged by a -51% loss!


To recap, the best way to choose investments is to start by selecting a good investment strategy. Good investment strategies are marked by objectivity, ease of understanding, a compelling track record, and ease of implementation.

Momentum is an objective metric, pointing investors to investments whose recent good performance indicates that such performance is likely to persist. There’s no guesswork involved; the numbers are what the numbers are.

Momentum is easy to understand and has a long, well-researched history of generating market-beating results. SMI’s momentum-driven strategies have outperformed the market as well. From 2000 to 2017, while the U.S. stock market generated an average annual return of +5.8%, the average annual returns turned in by Fund Upgrading, Dynamic Asset Allocation, and Sector Rotation were +8.5%, +10.8%, and +15.7% respectively.

SMI’s momentum strategies are designed to be easy to implement, with a focus on keeping trades to a minimum.

Bottom line? Taking advantage of the “anomaly” of momentum is likely to be an effective way to grow your financial resources over time, thus helping you make the most of what the Lord has entrusted to you.

Written by

Matt Bell

Matt Bell

Matt Bell is Sound Mind Investing's Managing Editor. He is the author of five biblical money management books and the teacher or co-teacher on three video-based small group resources. His latest book, Trusted: Preparing Your Kids for a Lifetime of God-Honoring Money Management, was published by Focus on the Family in 2023. Matt has spoken at churches, universities, and conferences throughout the country and has been quoted in USA TODAY, U.S. News & World Report, and many other media outlets.

Revolutionize Your Investing Approach

Unlock Your Wealth-Building Potential with Sound Mind Investing

Don't leave your investments to chance. Let Sound Mind Investing guide you to financial success. Experience the power of our simple, rules-based strategies and see your wealth grow.

Unlock your wealth-building potential for as little as $0.32 a day.